THE RISKS OF STRUCTURED PRODUCTS
If you are a bank investment customer you will no doubt have been offered a product that sound too good to be true – a structured product. This article aims to open your eyes to the risks of structured products. You might guess from this that we are not fans! These products are extensively marketed to bank customers and are portrayed as a low-risk way for risk averse customers to get the upsides of the stock market without all the downsides. The marketing materials explain how these products come with guarantees, but these guarantees are not always as cast iron as they might initially seem. We think that these products play to cautious investors’ worse fears, but do not necessarily give the returns they should. Their best use is in flat or falling markets where they can give positive returns, but should never be more than a small portion of your overall investment portfolio. As always, things are not so simple, so here is a quick guide to the risks of structured products. Risk While these products may seem attractive due to the guarantees provided by big institutions, you should always be aware of who is providing this guarantee. This is known as counterparty risk, and refers to how the risk of failure of the product is passed to a third party. Are you aware of how financially strong this 3rd party is (or even who this is)? There have been many examples in the past of these ‘guarantees’ becoming worthless since the company providing them is unable to back them up in times of severe stress. Also, it is common for these products to be launched when the stock market has dropped, meaning that equities are cheap anyway. Finally, you may not be aware that in certain circumstances your investments will not come with the backing of the Financial Services Compensation Scheme. With many products, if the counterparty guarantor goes bust the product will mature and you will not have any compensation payable. In our experience banks usually ignore or misrepresent these risks of structured products. Complexity We generally believe that unless there is a really good reason for it, you should avoid complexity. If you are unable to explain a structured product to a friend then it shouldn’t be for you since it will be too complicated. We feel that most of these products hide lots of complexity. One of the main risks of structured products is that you cannot understand them. If you cannot understand your investments something could go wrong with them and you would have no way of understanding this. High charges These are usually hidden in the typical way of banks. There are often high commissions paid to advisers selling these products along with other costs – up to 5-6% of the capital. This money comes directly from your investment even though it might not be presented exactly like that to you. With this, the risks of structured products are that you take more risk but get the same return you would have got for taking a lower level of risk. Returns Essentially you cannot divorce risk and return. We feel that you can achieve the level of returns of a structured product by having a low-risk diversified investment portfolio. Why invest in high charges and complexity when you can get the same or greater returns by a simpler method? The price of the guarantee usually means that returns are capped (meaning more profit for the bank in times of a rising market, not you).
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